Many people see owning a rental property as a ticket to prosperity. But wouldn’t it be nice if you could simply own an interest in a rental property, but not have any of the accompanying hassles? I’m far from an expert in this field, but let’s take a look at an REIT that invest in residential real estate.
What is an REIT?
REIT stands for Real Estate Investment Trust. From the National Association of REITs website:
A REIT is a company that owns, and in most cases, operates income-producing real estate such as apartments, shopping centers, offices, hotels and warehouses. Some REITs also engage in financing real estate. The shares of many REITs are freely traded, usually on a major stock exchange.
To qualify as a REIT, a company must distribute at least 90 percent of its taxable income to its shareholders annually. A company that qualifies as a REIT is permitted to deduct dividends paid to its shareholders from its corporate taxable income. As a result, most REITs remit at least 100 percent of their taxable income to their shareholders and therefore owe no corporate tax.
Since all the REIT income usually “passes through” straight to the shareholders, you are getting relatively direct exposure to real estate. You’re not investing in raw materials, a homebuilder, or some other derivative.
REZ Residential ETF
The iShares FTSE NAREIT Residential Plus Capped Index Fund (ticker REZ) is an ETF that tracks the FTSE NAREIT All Residential Capped Index. Here is the breakdown by industry breakdown and also the top 10 holdings.
As you can see, this is not the same as owning a single-family house, or even a bunch of single family houses. The fund holds interests in apartment complexes, healthcare facilities such as seniors housing communities and skilled nursing facilities, and also self-storage companies. For example, you can search online through the apartment complexes owned by Equity Apartments.
The annual expense ratio for REZ is 0.48%, which is on top of the built-in costs spent by each individual REIT. iShares also has ETFs focused on the different sectors such as Retail (retail stores, shopping malls) and Office/Industrial (office and industrial buildings).
ETF Advantages
One obvious advantage of owning an ETF instead of a single rental property is simplicity. You don’t have to spend time and effort dealing with finding tenants, maintenance issues, or problems with local government. You don’t have to search for properties to buy, negotiate prices, or obtain financing. You also don’t have to ever worry about keeping up cashflow, as there are no mortgage payment due each month.
Then there’s liquidity. If you need to sell, REZ has decent share volume so you can just type in a sell order and you’re done. You pretty much know the market price at all times.
Which One Is Better?
Here’s the tough question. Which will have the better return? With a single property, you are looking at monthly cashflow and property appreciation (plus possible tax benefits). With the ETF, you have your quarterly dividends and share price appreciation.
REZ currently has a current distribution rate of 5.11% based on its last quarterly dividend of 0.3003 cents per share, while the dividend yield listed on Yahoo! is 8.84% based on TTM (sum of all dividends paid out in the trailing twelve month period). According to the iShares page the Price/Earning ratio was 33 and the Price/Book ratio was 1.73 as 6/30/09.
The trailing 1-year total return of REZ is -39.64% according to Morningstar. (Too new for older numbers.) However, depending on how much your rental house was leveraged, many private investors could have done much worse. If you put $10,000 down on a $100,000 house and the house dropped just 5% in value, you would have essentially lost 50% of your $10,000 as well. I’m not sure what the total leverage of the REITs in this ETF are.
Also, we have to go back to the fact that this REIT doesn’t hold a bunch of detached single-family houses. Healthcare facilities seem like they would be a good source of income in a growing field. However, they could also be susceptible to political changes in Medicare rules.
I think its safe to say that any individual property could do worse or better than REZ. Perhaps a better question is how much you value diversification. Instead of putting your money into one property in one area, with an ETF you are instead owning a slice of thousands of different properties across the country. If you have high confidence in your abilities to select and manage a single property, that might be the better way to go.
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The only advantage with buying rental property over a REIT is that you can use leverage to increase your ROI. You cannot and shouldn’t borrow money to invest in a REIT.
I would like to see the differences in tax benefits of owning a property versus owning a REIT.
wow, thanks, i think i finally understand reit’s. i lived in an equity apt a couple of years ago. good management. interesting program where they encourage you to buy a home, via them if i remember correctly, where they put a portion of your rent toward the downpayment.
Thanks for the background on Reits — the only thing I don’t like is that they remind me too much of stocks, particularly the volatility. I also don’t like all the headaches involved with going solo and managing an investment property.
I’ve heard of some kind of investment groups that just own particular buildings, all together. Like in NYC, some real estate are owned by groups of doctors or what not, who have someone managing it for them. Would you know how you could get in on a particular building or into a particular small group of investors that invest in something more concrete, yet still have managers to do the other work? Would you know what kind of investing that is? I would like to invest in property, within a smaller group, to minimize the risk. But I really don’t like stuff that’s actively traded.
My pick RWX
On the international side, State Street’s $970 million SPDR DJ Wilshire International Real Estate ETF (Amex: RWX) tracks 156 publicly traded real estate securities in countries excluding the U.S. Sectors covered include real estate operating companies, regional malls, office building owners and diversified real estate companies.
Top countries represented are Japan, Australia, U.K., Hong Kong and France. Top holdings include shopping mall titan Westfield Group (ADX: WDC), diversified Japanese developer Mitsui Fudosan (TSE: 8810) and Europe’s leading commercial developer Unibail-Rodamco
If I am not mistaken, dividends paid by REITs are taxed at regular income tax rate. They are like interests rather than dividends. So it is better to have REITs in a tax deferred or ROTH IRA.
Another major difference is the tax benefit if you own the rental property versus through a REIT. With a rental property, you get to deduct the depreciation and for most people, this allows the investor to keep deferring taxes. Not so with a REIT. In fact, unless the REIT is held in a tax-deferred account, you must pay taxes at your income tax rate every year. Owning the rental property allows you to control when you pay the taxes — when you sell the property, you pay taxes at the lower capital gains rate.
Is it just me or does REZ (0.48%) look to be a more expensive version of VNQ (0.11%)? 5 of their top 10 holdings are the same and they pretty much track each other 100%. Why pay the extra .37% in fees and expenses?
Why not just directly invest in a REIT Stock vs. the ETF? You are just taking on extra expenses (via expense fee) that you can avoid.
All REITS are diversified across properities… so going into an ETF is esentially getting a diversified basket of diversified REITS……………… my advice is to skip the middle man and pick out your own REITs….. you can research them all on finance.yahoo.com
DebtHawk: REITs do use plenty of leverage through debt issuance.
REITs do not replicate income property ownership. REITs have highly paid management with accompanying staff and the income property owner can choose to capture the costs of active management if he/she so chooses. REITs do offer much more diversification through location and type of property, but it comes with just as much manager risk as an actively managed mutual fund. IMO apples and oranges.
@mimi – It is called a real estate syndicate. I was looking into them as well awhile back. But I have come to the conclusion I can’t afford it currently. I’m 24, and can’t come up with spare cash in such quantity.
@indexfunfan – You don’t even need to pay taxes when you sell the property if you do a 1031 exchange and get a bigger/more expensive rental property you can defer all tax obligations till you sell the new property (which you can just do another 1031).
As the OP has said, I really believe that it has to do with your need of diversification level and your ability & confidence in cash flow analysis. Well, that and how much spare cash you have…
REITs are a good, easy way to get into real estate as an investment. There are several pros and cons to buying REITs versus buying rentals. Rentals have better tax benefits and you can leverage. REITs are simple, diverse and no work is required. THe key question is do you want to be a landlord and basically take on a part time side business with a commitment of work? Even hiring a property manager and managing your manager is significantly more work than clicking ‘buy’ on a brokerage account to acquire REIT shares.
Besides REITS, there is a new ETF for UMM and DMM, unlike REITS, UMM and DMM do not own any properties, the ETF is based on the performance of the famous case Schiller index, it tracks about 10 major cities in the US, and it allows people to bet on both the UP side and the DOWN side of the real estate market. What do you guys think of this as opposed to REITS?
Personally, I own both (sort of). Owning ETF is NOT the same as owning a rental property. Trading ETF is much like trading stock with a high liquidity, and one does not feel the ownership because one does not have control. Why Warren Buffet folded so many companies into his big umbrella? He wanted to have control over those companies. Owning a rental property is more about control. One can do whatever to the property such as raising the rents. can one do this with the properties in the ETF? It’s possible, but not till one owns enough shares.
Contrast to Jonathan’s view, the economic situation actually made rental properties more attractive because more people want to find a place to live after they lost their houses. Even though a rental property may have lost its market value, but it is generating at least the same amount of cashflow as it used to. One cares less about the property’s market value, because the 27-1/2 year depreciation (tax benefit) is based upon the price it was acquired anyway. Also the tax law allows one to write off the loss from one’s oridinary income such as one’s salary from a regular job.
Reits or Rentals….just depends on your level of expertise and hands on approach. REITS are risky (to me) because I can’t count on the market staying sane. My rental properties return 18-25% ROI each year after we take out vacancies and what not. Its all about how much you know about that particular property/business model and how well its managed.
Warren Buffet would look at it a little differently:
1. Is it a business that I understand?
2. Is it a business that lots of people need or want?
3. Is it a business that is well managed?
We own real estate for our own personal growth and financial success. Last month we made 44% on our funds by buying cheap and rehabbing the properties then selling to a couple hedge funds in FL who want the 35% ROI on the monthly cashflow that it produces.
We’re loving this new “great recession” and we’re expanding our business as we speak.
Risk is inversely related to knowledge of that business. The more you know the less risky it is.
All the best in your endeavors
P.s. If you are interested in learning how to make 9-15% on your funds short or long term we can give you a free e book.